Many businesses want or need to borrow funds on a relatively short term basis, in order to finance various aspects of their business activities. Large, highly creditworthy business with substantial short term borrowing needs typically can obtain financing for those needs through a debt instrument known as commercial paper. Commercial paper permits a borrowing business to obtain short term financing directly from an investor (i.e., a lender), which may be, for example, a banking institution, a mutual fund, an insurance company, a trust fund, a pension fund, or the like.
Investors, for example, individuals, trusts, and money managers, generally perceive commercial paper to be a very low risk investment for two reasons. First, investors require that the business issuing the commercial paper be very large and meet the highest standards of creditworthiness. Second, while the term of commercial paper may be up to 270 days, most commercial paper is issued for an average term of 45 days; and over such a short period, the risk of default of such large businesses can be relatively accurately evaluated. Thus, commercial paper has significant protection against a risk of loss of principal as well as interest, that is, investment income. The borrowing businesses prefer the issuance of commercial paper over other forms of short term borrowing because, generally, commercial paper rates are lower, that is, less expensive, than rates associated with other forms of short term borrowing, such as short term bank lines of credit.
Generally, commercial paper is issued only for substantial borrowing needs and is issued in larger increments, for example, $100,000, in order to defray the significant costs related to the issuing process. Commercial paper is sold either directly to investors, or through dealers who charge a commission fee for arranging the transaction. Thus, commercial paper is basically a business IOU, issued at a relatively low rate of interest for a short period of time. As noted above, investors, for example, individuals, trusts, and money managers, purchase the commercial paper either directly or through dealers. These investors (i.e., lenders) are willing to participate in the commercial paper market because the issuers are large and highly creditworthy, and thus the short term risk of default is minimal.
While commercial paper can be an excellent way to fund short term borrowing wants or needs, this form of financing often is not available. For example, if a business is not large and highly creditworthy, it will be unable to tap into the commercial paper market. And even a large, highly creditworthy company won't be able to raise funds via commercial paper if its short term borrowing need isn't sufficiently large.
In these situations, a business typically must rely on other short term borrowing options—options that are more expensive than commercial paper financing. Examples of such options including bank loans and bank lines of credit. The interest rates charged for bank loans usually are based on a government-determined interest rate (e.g., the federal funds rate), LIBOR or a similar rate, or the prime rate. And bank-loan interest rates generally make the cost of bank-loan borrowing higher than that for commercial-paper borrowing. In the case of bank lines of credit, banks generally require a compensating balance—which in essence makes the cost of borrowing higher, or reduces the net amount of short term funds available, to a business that borrows via this option.
While commercial paper is an excellent debt instrument for large and highly creditworthy businesses to use in order to finance short term needs, a commercial paper market does not exist for smaller and less creditworthy businesses because of the increased risk perceived by investors. A commercial paper market also does not exist for borrowers with smaller needs because of the cost of issuance. Therefore, there is a need to provide a broader commercial paper market.